When Is a Lease a Lease?

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A revamped lease accounting standard in the works will likely put hundreds of billions of dollars in assets and obligations onto some companies’ balance sheets. That has had companies that will be most affected by the changes — such as airlines, retailers, and railroads — dreading any progress the rule-makers might make in creating a new standard. And executives of those companies have been pushing for the United States and international accounting boards not to apply the new rule to all leases.

Businesses may have gotten at least part of their wish, if the decisions made at a recent joint meeting of the Financial Accounting Standards Board and the International Accounting Standards Board are any indication. In one of the latest agreements made in the boards’ glacial move to overhaul the existing lease accounting rules, FAS 13 and IAS 17, they have chosen to exclude some leases from a final new standard.

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But since the boards have yet to explain how companies will know which leases will be exempted, it’s too early to tell how much of an impact this change could have on the effects of the new rule, which won’t be ready until at least 2011. It’s also too early to know whether it will lead to the restructuring of how current lease agreements are arranged.

After all, the standard-setters must tread lightly to avoid creating a new standard with defects that are similar to those critics have cited in the one U.S. companies have been following for 35 years. A particular concern about the current rule: bright-line rules can result in the structuring of leases to inaccurately reflect a company’s assets and liabilities.

Under the current rule, standard-setters believe, companies have been reworking leasing agreements to have them fall under the “operating lease” classification. In 2005 the Securities and Exchange Commission staff estimated that in this way, publicly traded companies are able to hide $1.25 trillion in future cash obligations. For example, as IASB chairman David Tweedie has noted, airlines’ balance sheets can appear as if the companies don’t have airplanes.

That could change under the new plan. Companies would have to capitalize assets that have traditionally fallen under the operating-lease classification. The result: companies that lease would appear more highly leveraged.

Earlier this year, FASB and the IASB released a paper outlining their initial thoughts on the plan, and they expect to propose a standard next year. But they’re still ironing out the details and have met six times so far this year on the subject. They have only recently begun deliberating how lessors will fit into this new regime.

At least one item they have agreed on: the premise. Rather than distinguish between capital and operating leases, companies should think about their “right to use” a leased item, whether it be plants, property, or equipment. Lessees will record that right as an asset and their obligation to pay future rental installments for that item as a liability.

In simple terms, “The basis of the right-to-use model is to move off of thinking about the thing [under lease] and think about the right to use the thing,” according to IASB board member James Leisenring.

For lessors, “the concept behind the right-of-use model is, I’ve given you an [item], it’s mine, so it should be on my books and I’m letting you use it, day by day,” explains FASB member Thomas Linsmeier.

Lessors will have to record a liability for their commitment to lending out an item and giving up the temporary right to use it. The thinking is that even though they are not using the item, the lessors still retain control of it and need to account for it. And their right to receive rental payments will be recorded as an asset.

Last week the standard-setters decided that lease contracts that are effectively purchases — in which an item is financed for ownership — will be scoped out of the new standard. Previously, the boards seemed to be tilting toward including all leases under a new standard. “A one-size-fits-all model for lessee accounting was the expedient approach, but it wasn’t the correct approach,” says Bill Bosco, who consults for the Equipment Leasing and Financing Association and sits on the International Working Group on Lease Accounting for the U.S. and international accounting boards.

The ELFA, which celebrated the move and has been very active in trying to influence the final standard, believes the boards are acting too quickly to meet their 2011 deadline and have accused them of not following due process. In particular, the discussion paper released earlier this year did not address lessors, so it did not give the public an opportunity to comment on the subject before a proposed standard is released, according to the trade group. In addition, the ELFA has always feared the rule would be too sweeping, and it doesn’t want it to apply to small or short-term leases. According to the ELFA, more than 90% of leases involve assets worth less than $5 million and have terms of two to five years.

Rule-makers have yet to decide on issues of materiality for this standard. And they have not yet seriously discussed how companies will transition into compliance with the new rule and whether they will have to rebook current leases. Moreover, an effective date has not been proposed.

The changes apparently won’t deter CFOs from their need for leasing agreements. In a survey of 846 CFOs and controllers in late September and early October, 59% told Grant Thornton they would continue to use leases or lease financing the same way they do now.

Still, says Bosco, with specifics in the new rule still being worked on, it may be too early to tell how it could affect lessees’ behavior. For instance, small businesses that use leasing agreements for their short-term capital needs will still need them. And the new rule may not allow much wiggle room. “All leases will be capitalized, so the ability to do any financial engineering, which [the boards] are very afraid of, will be severely diminished,” he says. “All leases will be on the balance sheet.”